Tag: shares

Company secretarial matters (or more commonly referred to as “CoSec“) are not overly exciting but do play a very important role when looking at any commercial transaction. Various matters can fall under the CoSec stable, but this article will focus exclusively on share issuances and updating the securities register (or more commonly referred to as the share register) following such issuances.

Background

In the haste of getting started or in the excitement of closing that first deal, many investors and entrepreneurs do not consider CoSec matters as a priority and often end up not properly implementing the investment. Most often, this leads to investors ending up without any share certificates evidencing their investment. Furthermore, their investments are not reflected in the securities register, which may prove detrimental to both the investor and the company as described below. First things first, however…

What is a share issuance?

In terms of section 38(1) of the Companies Act 71 of 2008, as amended (“the Act“), the board of directors of the company (“the Board“) may resolve to issue shares of the company at any time, subject to the conditions of such section being met. In addition to this, further conditions may regulate the issue of shares in certain instances, most notably when there is a subscription of shares (section 39), where consideration requirements must be considered (section 40) and where shareholder approval is required (section 41).

If the investment is successfully concluded and the relevant sections of the Act (as mentioned above) are complied with, the investment can be implemented. This means that the company can proceed to issue the shares that the Board has resolved to issue. This share issuance can then be evidenced by way of a certificate (some securities may also be uncertificated in certain instances). A share certificate is a commonly found example of a certificated security, and as such, must adhere to the provisions of section 51 of the Act, which include the fact that the certificate must state the name of the issuing company, the name of the person to whom the shares are being issued, the number and class of shares being issued, and any restriction on the transfer of such shares. The share certificate must furthermore be signed by two persons authorised by the Board, and serves as proof of ownership of the shares (in the absence of evidence to the contrary).

If the Board issues a share certificate which complies with the above, only one leg of the share issuance is complete. A very important secondary leg is the act of entering the investor’s details into the securities register as required in terms of section 50 of the Act (each company is obliged to have a securities register – even for uncertificated securities).

The importance of the securities register

Why is this second leg so important? Well, in terms of section 37(9) of the Act, only once the subscriber’s name is entered into the securities register, does he actually acquire the rights associated with the particular securities issued to him. As such, although there are contractual rights and obligations between the parties (in terms of the subscription and/or sale of shares agreement), for all intents and purposes, the investor does not acquire, and therefore cannot exercise, the rights awarded to him as proprietary holder in the company until the securities register has been updated.

Regrettably, in our experience, various investors are comfortable when they receive their issued share certificate (sometimes not even validly issued) and therefore do not request a copy of the updated securities register evidencing their investment. Especially where larger transactions are contemplated, parties require an accurate reflection of the shareholding position of the company to determine how the investment should proceed. Where the securities register has not been kept up to date and accurate, and when this is discovered during the due diligence investigations, such CoSec matters may cause unnecessary and costly delays for the company. Other matters may also be more difficult to administer post-transaction (especially where shareholder disputes are present).

Conclusion

Considering the above, it is advised that all CoSec matters are done accurately, diligently and kept in good order at all times to ensure that all parties’ rights are adequately protected, and that good corporate governance is maintained by the company. If you feel you might require any assistance with this, please do not hesitate to contact us.

(This post is the first in a series, giving practical information to start-up founders to gain a better understanding of the mechanics of preference shares. This post will focus on liquidation and dividend preferences.)

Venture capital investors are almost always aiming to invest in start-ups through “preferred” equity, typically referred to as preference shares. Preference shares trump ordinary shares, as the holders of preference shares normally receive preferential treatment in the event of a liquidation of the business. (For these purposes, a liquidation event can be the insolvency, a dissolution or a sale of the company.)

When start-ups enter funding stages, the good and/or lucky ones may end up with a few term sheets from an array of interested investors. These term sheets often come with an abundance of terms regarding the structure of the preference shares. As an inexperienced founder, this can be an overwhelming experience and it can be a daunting task to understand which terms are “standard” and which are particularly important. Venture capital investors have the upper hand due to their experience in this area – this is where professional advisors, such as start-up lawyers, come in handy in assisting the start-up and its founders.

The purpose of this series of articles is not to cover all aspects of term sheets, but to give you, a start-up founder, a better understanding of what preference shares really are, what to look out for and how they are typically structured during a series seed or series A investment.

What are preference shares?

When early-stage start-ups issue shares, there are generally two classes of people receiving shares: founders and investors. Founders typically receive ordinary shares and investors generally receive preference shares in return for their investment and risk taken.

The main characteristic of preference shares is that they provide for the preferential treatment of their holders and rank above ordinary shares in the event of a liquidation event. This means that if a company is unable to pay its debts or its business is sold, the investor will have a first claim on the company’s assets or sale proceeds over ordinary shareholders i.e. the founders. This is a protection mechanism given to the investor in return for the risk incurred when investing in the company.

Preference shares may further entitle the holder to preferential dividends, based on the profits of the company. Preference dividends are normally fixed at a certain annual percentage. As a preference shareholder, the investor will receive dividends ahead of ordinary shareholders when dividends are declared by the board of the company.

Liquidation preference

The liquidation preference determines how the pie is shared on a liquidation event. Preference shares almost always come with a liquidation preference, but the amount of the liquidation preference can differ. For example, the investor’s preference shares may come with a multiple of 1x purchase price. This means that upon a liquidation event, the investor will be paid 1x the issue price of his shares before the ordinary shareholders get anything. (For example, if the investor invested R1 million into the company, the investor wants R1 million paid back to him before the founders receive anything.) Similarly, if the investor’s liquidation preference is 2x purchase price, the investor will receive a multiple of 2x the issue price of his shares before the ordinary shareholders get anything.

As a start-up founder, you need to know what you are promising the investor. You might realise a few months down the line, when it’s too late, that you have given the investor a preference of 10x return on liquidation, leaving you and your co-founders with nothing. How a liquidation preference is structured can make a significant difference when the proceeds from a sale are split between the shareholders. Start-up founders should pay particular attention to this term.

Participating and non-participating

Generally, as seen above, the preference shareholders receive preferential returns. This means that they are paid back their initial investment plus some preferential payment (the liquidation preference multiple) before any other proceeds are disbursed. The extent to which additional funds, beyond this preference, are disbursed to investors depends on whether the equity is participating or non-participating preference shares. Participating preference shares take a share of the additional proceeds, along with ordinary shareholders, after receiving their preferential returns. For example, the preference shareholder participates in the equity apportionment in addition to receiving his liquidation preference. Holders of non-participating preference shares, however, only receive the preference plus any accrued dividends.

For example, an investor invests R2 million into a company at a 2x liquidation preference and at a post money valuation of R10 million (giving the investor a 20% stake in the company). The company is sold for a net sale price of R20 million. Therefore, the investor receives his 2x R2 million liquidation preference (receiving R4 million) and a R16 million surplus remains. If the preference shares are participating preference shares, the investor will receive an additional 20% of the surplus amount (a further R3.2 million). Alternatively, if the shares are non-participating preference shares, the other shareholders, i.e. the founders, will distribute the surplus among themselves according to their shareholding percentages.

An important point to note is that “participation” in venture capital deals generally refers to capital, however, it may also refer to a participation in pro rata dividends beyond the fixed preference dividend. As a founder, you must have clarity on this from the start.

Dividend preference: cumulative and non-cumulative

Preference shares often provide for a preferential dividend as well – investors with preference shares are entitled to receive dividends before ordinary shareholders.

Dividends increase the total return for the investors and decrease the total return for ordinary shareholders. Dividends are often stated as a percentage of the share issue price for the preference shares (for example, 8% of the total share issue price). There are at least three general ways dividends are structured in venture capital deals: (i) cumulative dividends; (ii) non-cumulative dividends; and (iii) dividends on preference shares only when paid on the ordinary shares.

Dividend structures (i) and (ii): If a company does not declare a dividend in respect of a particular year, then preference shareholders with a right to non-cumulative dividends would lose the right to receive a dividend for that year. However, preference shareholders with a right to cumulative dividends would be able to carry over their right to receive a dividend for that year, entitling them to receive that dividend in the future, together with the dividend declared in that next year (before any dividends are payable to ordinary shareholders). Clearly, cumulative dividends are the most beneficial to the investor and the most burdensome on the founders (being ordinary shareholders).

Dividend structure (iii): Where dividends are paid on the preference shares only if paid on the ordinary shares, the preference shares are treated as if they had been converted into ordinary shares at the time the dividend is declared. This is the least beneficial to the investor and the most beneficial to the founders.

If not clearly understood, agreeing to a cumulative dividend can lead to significant and unexpected monetary burdens on the available and distributable profits for you and your co-founders. As a start-up founder, you must understand the different ways in which dividends can be structured. You need to consider the company’s projected cashflow from now until the expected exit and the impact the dividend preference has on shareholders.

Concluding remarks

We trust that the issues highlighted above will give you some insight and guidance as to why it is so important to have a good understanding of the preference share terms you are likely to find in a term sheet. If you would like to discuss any of these topics in more detail, please feel free to contact our Start-up Law team and we’ll gladly assist.